NPV - Net Present Value
Summarized by Sam Mishra, MBA (MIT Sloan)
Where:
NPV is a framework which aids in managerial decision making. Should a company buy a piece of land and build a factory on it? Should a company buy a set of robots to aid in its manufacturing? Should a company invest in a specific project which promises good future cash flows? How do you evaluate the real value of a gas station you want to buy? Or a coffee stand? In general, to answer such questions, NPV should be calculated for each project and those investments with a positive NPV should be pursued.
However, the caveat to focusing only on NPV or on the numbers may result in incorrect strategic decisions where a project the NPV is applied on is interdependent on other projects and vice-versa. Also, in evaluating new ventures / new product ventures, risk / uncertainty needs to be taken into account; for which NPV is too simplistic a model to rely on. For such cases, advanced valuation models such as risk-adjusted NPV calculations and investments as options should be used.
To find the discount rate R in the above equation, CAPM (Capital Asset Pricing Model) is frequently used. Our CAPM framework page illustrates through a simplae example how R is calculated from an investment's riskiness or beta, the risk free rate of return (or US treasury's rate of return) , and the rate of return from the stock market. Please check our Special Book Offers section for real life applications of NPV.
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